This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
In calm markets, the volatility index generally sits somewhere around 10. In the recent market upheaval, it has touched the 30s. The volatility index measures how quickly the market expects stock prices to change. The higher the index, the wilder the anticipated swings in price.
That spike in the volatility index raises a key question: Should you buy stocks now, or wait? As simple as that question is to ask, the answer depends as heavily on you as an investor as it does on stocks themselves.
You need to be able to have a long-term focus
High volatility means stocks are expected to move aggressively -- sometimes up, sometimes down. When that volatility is combined with the bear market we're in, there's very real risk that there will be more aggressive moves downward. As a result, it's critically important that you have a long-term focus with any money you're willing and able to invest in the market.
After all, if you buy and the stocks you purchase later go down, you will have less in total net worth than you would have if you had just held cash. It can be a very frustrating feeling, as if you're throwing good money after bad.
With a long-term focus, however, you can better recognize that when you buy shares and they go down, you still have the same number of shares -- and thus ownership stake -- as you did before. In addition, it gets easier to see how investing the same number of dollars after the stock crashes buys more shares than it did before the crash, helping new money go that much further.
A reasonable valuation estimate helps, too
Speaking of converting dollars to shares, investing when volatility spikes gets much easier if you have a good valuation tool, such as the discounted cash flow model, at your side. With the discounted cash flow model, you estimate the amount of cash the company will generate in the future. Then, you dial back (or discount) that cash flow based on how far in the future you expect the company to earn it. Add up those discounted cash flows and the total is your estimate of what the company is worth.
You'll never get it perfect -- you are predicting the future, after all -- but if you do your homework and seek to really understand the business, you can often get reasonably close. The power of getting reasonably close, though, is that sometimes, severe market volatility in a bear market drives a company's stock well below your estimate of its fair value. When that happens, you can swoop in and buy shares for less than you think they're worth.
Turning a volatility-driven market crash into a bargain hunting expedition is an opportunity to take advantage of a very choppy market, and it's one you usually only get when the volatility index is high.
Diversification reduces the impact when you get it wrong
Of course, there's usually a good reason for a crashing market and spiking volatility index. In this case, it's the combination of stagflation risks and rising interest rates. That combination can make it very difficult for weaker companies to survive. It can also radically throw off your otherwise reasonable valuation estimates, as rapidly rising costs can seriously mess with a business's ability to generate cash.
As a result, it is incredibly important to spread your investments out across multiple companies in different industries. That way when (not if) one of your investments fails, the loss of that investment will have far less of an impact on your overall portfolio than it would have had if that company had been the only one you owned.
Put it all together and you have a path to buy even when volatility spikes
It's scary to invest when the market is down and volatility is high. With a combination of a long-term focus, a decent valuation estimate, and diversification on your side, you've at least got a chance to turn it to your advantage. It's not easy to invest in times like these, but history suggests that if you're able to, you're likely to come out successful on the other side. So make today the day you get these tools in your arsenal and are well prepared to invest despite spiking volatility.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
